The High Dividend Fallacy

For the last few years a number of analysts urged income-seeking investors to buy high-yielding stocks instead of different types of bonds. I haven’t done that, because there’s a risk-return trade off that’s ignored in this advice. The trade off became obvious last Friday when JPMorgan announced a large hedging loss and its stock declined sharply.

You can generate higher income from a high dividend stock than from treasury and investment-trade corporate bonds. And best of all, that dividend is likely to grow over time. Most dividend-paying corporations routinely increase their dividends, and the increases often exceed the inflation rate. That’s the good part.

The bad part is that dividend-paying stocks still have stock market and company risk. That doesn’t matter if you never plan to sell the stocks or aren’t concerned with fluctuations in the value of the stock. In that case, as long as the company is solid enough to pay its dividend and increase it indefinitely, you can be a buy-and-hold investor and buy stocks with high dividend yields. But you need to know before buying that fluctuations in the value of the stock easily could wipe out several years’ worth of additional income in a short time. If the fluctuations will bother you or reduce your standard of living, then high-yielding stocks aren’t a good replacement for bonds. Above all, be sure any stocks you buy have strong businesses and enough cash flow to pay their dividends.